The Motley Fool

What Is: A Falling Knife

The term falling knife comes from the stock-market saying, “Never try to catch a falling knife.” The implication is that when a share falls, there may be a good reason for the fall… and it may continue to fall. Consequently, you should not even think about buying the share until it has come safely to rest. And even then, picking up the knife may turn out to be a trap.

The trouble with a falling knife is to know when exactly the share has stopped falling. Additionally, it is quite important to distinguish between falling knives and panic selling – that is when shares fall sharply because of an overreaction to unsavoury news.

According to Brandes Institute, catching falling knives can actually be lucrative. On the one hand, Brandes found that between 1986 and 2002 falling knives posted a higher bankrupt rate over the three-year period following their initial drop. However, it also found that falling knives outperformed the overall market by a wide margin. Their conclusion was that investors who never catch falling knives may be foregoing significant opportunities.

The upshot is that picking up the occasional falling knife in the hope of finding one that rebounds can be hit-and-miss. But if you are keen on chancing your luck you may want to decide if the falling knife is merely a temporary situation. That means analysing carefully if the price drop is justified or caused by a market overreaction.

If your analysis indicates that the drop may be short-lived, or that it is entirely unwarranted, then this may provide you with an opportunity to buy a share that you may want to own for the long-term.

In the end, the key is to understand the businesses you’re watching, have an idea what they’re worth, and buy when the market price gives you an opportunity to buy below the company’s intrinsic value… well, buy!